Best Execution, Trading Capacity and Quotation

A customer enters an order to buy 500 shares of SBUX through his online broker-dealer. The online broker-dealer routes the order to the best available market. Typically, that would be whichever market making firm were displaying the lowest ASK at the time.

The online broker-dealer is required to achieve best execution when filling customer orders. Typically, price determines the best execution, but FINRA allows firms to consider execution quality, as well. Execution quality includes the speed of execution and the % of orders that get filled by the market maker, called the "fill rate."

Price improvement doesn't happen often, but when it does the customer's order is filled at a better price than was displayed at the time of entry. For example, if the quote for ABC is Bid: $20.00, Offer: $20.05, let's say a customer places a market order to sell. That means he's willing to accept $20.00 for his shares. But, when his broker calls, the customer is informed he was filled at $20.04, 4 cents-per-share higher than the Offer/Ask at the time he placed the order.

Why this happens isn't clear. One explanation is that market makers earn profits on minute movements in a security's market price; therefore, sometimes they just act to keep the market for the security smooth, liquid. It's also possible that in a fast market, sometimes mistakes are made that favor investors.

Although the price of execution is important, FINRA allows firms to consider speed of execution, fill rates and price improvements when routing customer trades to market makers. Therefore, if a market maker's fill rates and/or price improvements are superior, the broker-dealer routing orders to them would be conforming to best execution requirements even in those cases where another market maker was quoting a better price.

The word "broker-dealer" is hyphenated for a reason. In any transaction, a broker-dealer can "broker" the transaction or "deal" the security. FINRA members either get a customer order filled between the customer and a market maker, or they are market makers themselves. A firm is never acting in both roles on the same trade.

When acting as a broker in the trade, a FINRA member indicates to the customer they acted in an agency capacity. If the firm is a market maker, they act in a principal capacity in these trades, as they either buy from, or sell to, an investor.

Also, if the firm is a market maker, it may act as principal in a trade with a retail investor by adding a markup to a purchase order, or a markdown to a sale. In these trades, the firm adds a few pennies to the “ask” when a customer buys (markup), or subtracts a few pennies from the “bid” when a customer sells (markdown). These are referred to as "net transactions."
Either way, the firm must give the customer a fair and reasonable price, and disclose in which role they acted. When acting in an agency capacity, the firm adds a commission. When making markets, the firm earns the difference between their Bid and Ask, known as the spread. And, when acting in a principal capacity with their retail customers, the firm earns a markup or markdown.


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